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Faculty & Research

Research Colloquium 2013-2014

We're looking forward to seeing you at our upcoming Distinguished Speaker Series that kicks off November 12, 2014, here at UC Irvine with Kimberly Cripe, president and CEO of CHOC Children's, one of the top pediatric health care systems in the nation. More information coming soon!

 

Accounting

 

Professor Terry Shevlin

Title: "The Association Between Book-tax Conformity and Earnings Managment"

Co-authors: Bradley Blaylock and Fabio Gaertner

Accepted at:  Review of Accounting Studies

February 2014

 

There is an on-going debate in the literature about the costs and benefits of conforming book and taxable income. Proponents argue that increased book-tax conformity will reduce aggressive financial reporting because managing earnings up increases taxes and will curtail abusive tax shelters because managing taxes down decreases earnings reported to shareholders. We use a panel of 139,536 firm-year observations across 34 countries over the period 1996-2007 to test whether high levels of book-tax conformity are associated with less earnings management and find that higher book-tax conformity is associated with significantly more, not less, earnings management. We conclude that one of the primary claimed benefits of increasing book-tax conformity, more truthful financial reporting with less earnings management, is unlikely to be as large as previously thought.

 

 

Professor Radhika Lunawat

Title: "An Experimental Investifation of Reputation Effects of Disclosure in an Investment/trust Game"
Accepted at:  Journal of Economic Behavior & Organization

February 2014

 

This paper examines experimentally the reputation building role of disclosure in an investment/trust game. It provides experimental evidence in support of sequential equilibrium behavior in a finitely repeated investment/trust game where information asymmetry raises the possibility of voluntary disclosure. I define two regimes, namely disclosure regime and no-disclosure regime and it is only in the disclosure regime that such disclosure of private information is a possibility. I compare investment levels across two regimes and find the startling result that investment is lower in disclosure regime. I find that this lower investment is attributable to the fact that the prior probability with which an investor in the disclosure regime believes that a manager is trustworthy is significantly lower than the prior probability with which an investor in the no-disclosure regime believes that a manager is trustworthy. I introduce a two-stage experimental design to homogenize prior beliefs about managers’ trustworthiness and find that after such homogenization, investment is higher in disclosure.

 


 

 

Professor Joanna Ho

Title: "Performance Measures, Consensus on Strategy Implementation, and Performance: Evidence from the Operational-level of Organizations"

Co-authors: Steve Wu and Anne Wu

Accepted at:  Accounting, Organizations and Society

December 2013

 

In this article, we examine how consensus between operational-level managers and employees on strategy implementation affects the effectiveness of performance measures and employee performance. We use field-based surveys and proprietary archival data from a Taiwanese financial services company to answer our research questions. Consistent with the predictions of person-organization fit theory, we find that consensus on the implementation of the customer-oriented strategy is positively associated with frontline employees' performance. Our results also indicate that the incentive effect of using performance measures in performance evaluation and promotion is stronger for employees with a higher level of consensus. Our findings suggest that consensus is critical to the success of an organization's strategy implementation and the effectiveness of performance measures.

 

 

Professor Lucile Faurel

Title: “Economic Determinants and Information Environment Effects of Earnouts: New Insights from SFAS 141 (R)”
Co-authors: Brian Cadman and Richard Carrizosa

Accepted at:
Journal of Accounting Research
December 2013

 

Contingent considerations (“earnouts”) in acquisition agreements provide sellers with future payments conditional on meeting certain conditions. Prior research provides evidence that acquiring firms use earnouts to minimize agency costs associated with acquisitions. Using earnout fair value information recently mandated by SFAS 141(R), we provide new insights into the economic determinants to include earnout provisions in acquisition agreements including motivations to resolve moral hazard and adverse selection problems, bridge valuation gaps, and retain target firm managers. We document variations in initial earnout fair value estimates and earnout fair value adjustments that correspond with these underlying motivations. We also provide evidence that target managers stay longer with the firm after the acquisition when earnouts are included primarily to retain target managers. Finally, we demonstrate that earnout fair value adjustments required by SFAS 141(R) provide valuable information to market participants and are negatively associated with the likelihood of contemporaneous and future goodwill impairments.

 


  

Professor Devin Shanthikumar

Title: "Do Security Analysts Speak in Two Tongues?"

Co-author: Ulrike Malmendier

Accepted at:  Review of Financial Studies

November 2013

 

Why do security analysts issue overly positive recommendations? We propose a novel empirical approach to distinguish strategic motives (such as generating small-investor purchases and pleasing management) from non-strategic motives (genuine over-optimism). We argue that non-strategic distorters tend to issue both positive recommendations and optimistic forecasts, while strategic distorters speak in two tongues: they issue overly positive recommendations but less optimistic forecasts. We show that the incidence of strategic distortion is large. It is systematically related to analyst affiliation and other proxies for incentive misalignment, but our two-tongues metric reveals strategic distortion beyond those indicators and provides a new tool for detecting incentives to distort that are hard to identify otherwise

 


 

Professor Joanna Ho

Title: "Auditor Choice and Audit Fees in Family Firms: Evidence from the S&P 1500"

Co-author: Fei Kang (Ph.D. alumna)

Accepted at:  Auditing: A Journal of Practice & Theory

October 2013

 

We examine auditor choice and audit fees in family firms using data from Standard and Poor’s (S&P) 1500 firms. We find that, compared to non-family firms, family firms are less likely to hire top-tier auditors due to the less severe agency problems between owners and managers. Our results also show that family firms on average incur lower audit fees than non-family firms, which is driven by family firms’ lower demand for external auditing services and auditors’ perceived lower audit risk for family firms. Our additional analysis indicates that the tendency of family firms to hire non-top-tier auditors and to pay lower audit fees is stronger when family owners actively monitor their firms. 

 

Professors Mort Pincus and Siew Hong Teoh

Title: "Mispricing of Book-Tax Differences and the Trading Behavior of Short Sellers and Insiders"

Co-author: Sabrina Chi (Ph.D. alumna)

Accepted at:  The Accounting Review

October 2013

 

We find evidence that investors misprice information contained in book-tax differences (BTDs), measured as the ratio of taxable income to book income, TI/BI. Low TI/BI predicts worse earnings growth and abnormal stock returns than high TI/BI. We find that short sellers and insiders arbitrage BTD mispricing, but the arbitrage is imperfect because of constraints on short selling and insider trading. Under SFAS No. 109 the predictability is stronger for TEMP/BI, the temporary component of TI/BI, which reflects greater managerial discretion. The results are incremental to a large set of known accruals-based anomaly predictors. We suggest that a sunshine policy of disclosing a reconciliation of book and taxable incomes can reduce mispricing of BTDs and improve capital market resource allocation.

 

Professor Terry Shevlin

Title: "Incentives for Tax Planning and Avoidance: Evidence from the Field"

Co-authors: John Graham, Michelle Hanlon and Nemit Shroff

Accepted at:  The Accounting Review

October 2013

 

We analyze survey responses from nearly 600 corporate tax executives to investigate firms’ incentives and disincentives for tax planning. While many researchers hypothesize that reputational concerns affect the degree to which managers engage in tax planning, this hypothesis is difficult to test with archival data. Our survey allows us to investigate reputational influences and indeed we find that reputational concerns are important – 69% of executives rate reputation as important and the factor ranks second in order of importance among all factors explaining why firms do not adopt a potential tax planning strategy. We also find that financial accounting incentives play a role. For example, 84% of publicly traded firms respond that top management at their company cares at least as much about the GAAP ETR as they do about cash taxes paid and 57% of public firms say that increasing earnings per share is an important outcome from a tax planning strategy.  

 

Professor Terry Shevlin

Title: "Some Personal Observations on the Debate on the Link Between Financial Reporting Quality and the Cost of Equity Capital"

Accepted at:  Australian Journal of Management

October 2013

 

Within the last decade there has been much written about the possible link between the quality of a firm’s external financial reporting and its cost of equity capital.  In this paper I provide my personal observations about the literature.  I make the following points.  First, I find the Francis, Lafond, Olsson and Schipper (2005) paper interesting and innovative.  This paper documents a positive association between portfolio returns formed on the basis of accrual quality and firms’ realized returns after controlling for the Fama-French three factors.  Francis et al. conclude that accrual quality is a priced risk factor.  Second, while this conclusion might be too strong based on their results, I think the Core, Guay and Verdi (2008) critique of the Francis et al. claim is also too strong and does not lead me to reject accrual quality as a priced risk factor.  Third, the evidence of an association between financial reporting quality and implied cost of capital estimates is robust.  However several papers question the construct validity of these measures which are based on analyst earnings forecasts.  I discuss these papers and conclude that the implied cost of capital does have empirical validity. Finally, various papers model the relation between financial reporting quality and cost of capital and, while interesting, mostly restrict themselves to a single factor asset pricing model.  However, restricting the model to a single factor model by assumption rules out the possibility of information quality being a separately priced risk factor and further restricts the role information quality to informing about a firm’s covariances (or estimation error in the CAPM beta) because it is assumed that information quality is diversifiable.  I think whether something is diversifiable is an empirical question that cannot be resolved by assumption within a theoretical model.
 

Professor Siew Hong Teoh

Title: "Tone Management"

Co-author: Xuan Huang (Ph.D. alumna) and Yinglei Zhang

Accepted at:  The Accounting Review

October 2013

 

We investigate whether and when firms manage the tone of words in earnings press releases, and how investors react to tone management. We estimate abnormal positive tone, ABTONE, as a measure of tone management from residuals of a tone model that controls for firm quantitative fundamentals such as performance, risk, and complexity. We find that ABTONE predicts negative future earnings and cash flows, is positively associated with upward perception management events, such as, just meeting/beating thresholds, future earnings restatements, SEO and M&A, and is negatively associated with a downward perception management event, stock option grants. ABTONE has a positive stock return effect at the earnings announcement and a delayed negative reaction in the one and two quarters afterwards. Balance sheet constrained firms and older firms are more likely to employ tone management over accruals management. Overall, the evidence is consistent with managers using strategic tone management to mislead investors about firm fundamentals.

 


   

Professor Terry Shevlin

Title: "Does Voluntary Adoption of a Clawback Provision Improve Financial Reporting Quality?"

Co-authors: Ed deHaan and Frank Hodge

Accepted at:  Comtemporary Accounting Research

May 2013

 

We examine whether financial reporting quality improves after firms voluntarily adopt a compensation clawback provision. Clawback provisions allow companies to recoup excess incentive pay in the event of an accounting restatement, and are intended to ex ante deter managers from publishing misstated accounting information and to ex post penalize managers who do so. For the period 2007 – 2009, our difference-in-differences analysis reveals significant improvements in both actual and perceived financial reporting quality following clawback adoption, relative to a propensity-matched set of control firms. We also find an increase in compensation for CEOs who are subject to new clawback provisions, as well as an increase in the sensitivity of cash compensation to accounting performance. In cross-sectional tests, our findings indicate that “robust” clawback provisions, those that apply to restatements caused by either intentional or unintentional errors, have an incrementally larger impact on financial reporting quality and compensation than do clawback provisions that apply only to restatements involving fraud.

 


  

Professor Siew Hong Teoh and Ph.D. Student Peng-Chia Chiu

Title: "Board Interlocks and Earnings Management Contagion"

Co-author: Feng Tian

Accepted at:  The Accounting Review

Dectember 2012

 

We test whether earnings management spreads between firms via shared directors. We find that a firm is more likely to manage earnings when it shares a common director with a firm that is currently managing earnings and is less likely to manage earnings when it shares a common director with a non-manipulator. Earnings management contagion is stronger when the shared director has a leadership or accounting-relevant position (e.g., audit committee chair or member) on its board or the contagious firm’s board. Irregularity contagion is stronger than error contagion. The board contagion effect is robust to controlling for endogenous matching of firms with directors, fixed firm/director effects, incidence of M&A, industry, and contagion via a common auditor or geographical proximity. These findings support the view that board monitoring plays a key role in the contagion and quality of firms’ financial reports.

 


 

Professors David Hirshleifer and Siew Hong Teoh
Title: “Overvalued Equity and Financing Decisions"
Co-author: Ming Dong
Accepted at: The Review of Financial Studies

September 2012

We test whether and how equity overvaluation affects corporate financing decisions using an ex ante  misvaluation measure that filters firm scale and growth prospects from market price. We find that equity issuance and total financing increase with equity overvaluation; but only among overvalued stocks; and that equity issuance is more sensitive than debt issuance to misvaluation. Consistent with managers catering to maintain overvaluation and with investment scale economy effects, the sensitivity of equity issuance and total financing to misvaluation is stronger among firms with potential growth opportunities (low book-to-market, high R&D, or small size) and high share turnover.

  


 

Professor Devin Shanthikumar

Title: "The Stock Selection and Performance of Buy-Side Analysts"

Co-authors: Boris Groysberg, Paul Healy, and George Serafeim

Accepted at:  Management Science

September 2012

 

Prior research on equity analysts focuses almost exclusively on those employed by sell-side investment banks and brokerage houses. Yet investment firms undertake their own buy-side research and their analysts face different stock selection and recommendation incentives than their sell-side peers. We examine the selection and performance of stocks recommended by analysts at a large investment firm relative to those of sell-side analysts from mid-1997 to 2004. We find that the buy-side firm’s analysts issue less optimistic recommendations for stocks with larger market capitalizations and lower return volatility than their sell-side peers, consistent with their facing fewer conflicts of interest and having a preference for liquid stocks. Tests with no controls for these effects indicate that annualized buy-side Strong Buy/Buy recommendations underperform those for sell-side peers by 5.9% using market-adjusted returns and by 3.8% using four-factor model abnormal returns. However, these findings are driven by differences in the stocks recommended and their market capitalization. After controlling for these selection effects, we find no difference in the performance of the buy- and sell-side analysts’ Strong Buy/Buy recommendations.
  


 

Professor Devin Shanthikumar

Title: "Consecutive Earnings Surprises: Small and Large Trader Reactions"

Accepted at:  The Accounting Review

June 2012

 

Prior research demonstrates that investors respond differently to earnings surprises that are part of a string of consecutive earnings increases or surprises than to those that are not. To shed light on who values these patterns, I compare trading responses of small and large traders to earnings surprises that occur during a series of positive or negative surprises. I find that the relative intensity of small traders’ trading (and to a lesser extent medium traders) to earnings surprises generally increases as a series progresses. Small traders respond more negatively to the second (third) negative surprise in a series than to the first (second), and more positively for the first three surprises in a positive series. Moreover, I find that announcement period returns are related to the trading of small and medium traders. These results suggest that less sophisticated smaller traders, responding to earnings series, contribute to previously documented pricing patterns.
  


 

Professor Terry Shevlin

Does Voluntary Adoption of a Clawback Provision Improve Financial Reporting Quality?
Co-Authors:  Ed deHaan and Frank Hodge
Forthcoming in Contemporary Accounting Research

Accepted May 2012

 

We examine whether financial reporting quality improves after firms voluntarily adopt a compensation clawback provision. Clawback provisions allow companies to recoup excess incentive pay in the event of an accounting restatement, and are intended to ex ante deter managers from publishing misstated accounting information and to ex post penalize managers who do so. For the period 2007 – 2009, our difference-in-differences analysis reveals significant improvements in both actual and perceived financial reporting quality following clawback adoption, relative to a propensity-matched set of control firms. We also find an increase in compensation for CEOs who are subject to new clawback provisions, as well as an increase in the sensitivity of cash compensation to accounting performance. In cross-sectional tests, our findings indicate that “robust” clawback provisions, those that apply to restatements caused by either intentional or unintentional errors, have an incrementally larger impact on financial reporting quality and compensation than do clawback provisions that apply only to restatements involving fraud.

 


 

Professors David Hirshleifer and Siew Hong Teoh
Title: “Are Overconfident CEOs Better Innovators?"
Co-author: Angie Low
Accepted at: The Journal of Finance

January 2012

Previous empirical work on adverse consequences of CEO overconfidence raises the question of why firms would hire overconfident managers. Theoretical research suggests a reason, that overconfidence can sometimes benefit shareholders by increasing investment in risky projects. Using options- and press-based proxies for CEO overconfidence, we find that over the 1993-2003 period, firms with overconfident CEOs have greater return volatility, invest more in innovation, obtain more patents and patent citations, and achieve greater innovative success for given research and development (R&D) expenditure. Overconfident managers only achieve greater innovation than non-overconfident managers in innovative industries. Our findings suggest that overconfidence may help CEOs exploit innovative growth opportunities.
   


 

Professor Alexander Nekrasov
Title: “Using Earnings Forecasts to Simultaneously Estimate Firm-Specific Cost of Equity and Long-Term Growth”
Co-author: Maria Ogneva
Accepted at: The Review of Accounting Studies

August 2011

A growing body of literature in accounting and finance relies on implied cost of equity (COE) measures. Such measures are sensitive to assumptions about terminal earnings growth rates. In this paper we develop a new COE measure that is more accurate than existing measures because it incorporates endogenously estimated long-term growth in earnings. Our method delivers COE (growth) estimates that are significantly positively associated with future realized stock returns (future realized earnings growth). Moreover, the predictive ability of our COE measure subsumes that of other commonly used COE measures and is incremental to commonly used risk characteristics. Our implied growth measure fills the void in the earnings forecasting literature by robustly predicting earnings growth beyond the five-year horizon.

  


 

Professor Terry Shevlin

Tax Avoidance, Large Positive Temporary Book-Tax Differences, and Earnings Persistence
Co-Authors: Brad Blaylock, Ryan Wilson
Accepted at: The Accounting Review

July 2011
 

We investigate why temporary book-tax differences appear to serve as a useful signal of earnings persistence (Hanlon 2005). We first test and show that temporary book-tax differences provide incremental information over the magnitude of accruals for the persistence of earnings and accruals.  We then opine that there are multiple potential sources of large positive book-tax differences. We predict and find that firms with large positive book-tax differences likely arising from upward earnings management (tax avoidance) exhibit lower (higher) earnings and accruals persistence than other firms with large positive book-tax differences. Finally, we find significant variation in current period earnings and accruals response coefficients and insignificant hedge returns in period t+1, consistent with investors being able to look through to the source of large positive book-tax differences (earnings management and tax avoidance), allowing them to correctly price the persistence of accruals for these subsamples.

 


 

Professor Lucile Faurel

Title: “Manager-Specific Effects on Earnings Guidance: An Analysis of Top Executive Turnovers.”
Co-authors: Francois Brochet and Sarah McVay

Accepted at:
Journal of Accounting Research
July 2011

 

We investigate how managers contribute to the provision of earnings guidance by examining the association between top executive turnovers and guidance. Although firm and industry characteristics are important determinants of guidance, we conclude that CEOs participate in firm-level policy decisions, whereas CFOs are involved in the formation or discussion of guidance. Among firms that historically issued frequent guidance, breaks in guidance following CEO turnovers are relatively permanent and are potentially attributable to firm-initiated changes in guidance policy. Breaks following CFO turnovers, however, likely reflect uncertainty on the part of the newly appointed executive—they are concentrated in the two quarters following the turnover, are associated with the background of the newly appointed CFO, and extend to the relative precision of the guidance. Among firms that did not issue guidance historically, we find some evidence that newly appointed externally hired CEOs increase the likelihood of providing guidance.

 


 

Professors David Hirshleifer and Siew Hong Teoh
Title: “Limited Investor Attention and Stock Market Misreactions to Accounting Information”
Co-authors: Sonya Lim
Accepted at: Review of Asset Pricing Studies

April 2011

We document considerable return comovement associated with accruals after controlling for other common factors. An accrual-based factor-mimicking portfolio has a Sharpe ratio of 0.16, higher than that of the market factor or the SMB and HML factors of Fama and French (1993). According to rational frictionless asset pricing models, the ability of accruals to predict returns should come from the loadings on this accrual factor-mimicking portfolio. However, our tests indicate that it is the accrual characteristic rather than the accrual factor loading that predicts returns. These findings suggest that investors misvalue the accrual characteristic, and cast doubt on the rational risk explanation.

 


 

Professor Siew Hong Teoh
Title: “Data Truncation Bias, Loss Firms, and Accounting Anomalies”
Co-authors: Yinglei Zhang
Accepted at: The Accounting Review

February 2011

Ex post trimming of extreme returns observations that are not data errors causes spurious inferences in tests of market efficiency and behavioral explanations for anomalies. Trimming causes a downward truncation bias in estimated mean returns that is stronger in ex ante subsamples with more loss firms and in which return distributions are more right-skewed. There is an asymmetric U-shaped relation between return right-skewness and loss frequency across deciles of negative return predictors (Accruals, ΔNOA, and NOA), and a downward sloping relationship for positive return predictors (CFO and FCF). Consequently, a least-trimmed square (LTS) 1% deletion of returns induces a spurious inverted-U-shaped relation between returns and negative predictors, and an exaggerated positive relation for positive predictors. Thus, the resulting trimmed relations do not reject behavioral explanations for these anomalies. Trimming also induces a spurious loss anomaly. These findings highlight that in return prediction studies, observations should not be deleted based upon the values of the dependent variable, only based upon clearly identified data errors.

  


   

Professor Siew Hong Teoh
Title: “The Accrual Anomaly: Risk or Mispricing?”
Co-authors:
David Hirshleifer and Kewei Hou
Accepted at: Management Science

December 2010

We document considerable return comovement associated with accruals after controlling for other common factors. An accrual-based factor-mimicking portfolio has a Sharpe ratio of 0.16, higher than that of the market factor or the SMB and HML factors of Fama and French (1993). According to rational frictionless asset pricing models, the ability of accruals to predict returns should come from the loadings on this accrual factor-mimicking portfolio. However, our tests indicate that it is the accrual characteristic rather than the accrual factor loading that predicts returns. These findings suggest that investors misvalue the accrual characteristic, and cast doubt on the rational risk explanation.

  


 

Professor Siew Hong Teoh
Title: “Short Arbitrage, Return Asymmetry and the Accrual Anomaly”
Co-authors:
David Hirshleifer and Jeff Jiewei Yu
Accepted at: Review of Financial Studies

December 2010

We find a positive association between short-selling and accruals during 1988-2009, and that asymmetry between the up- and down- sides of the accrual anomaly is stronger when constraints on short-arbitrage are more severe (low availability of loanable shares as proxied by institutional holdings). Short arbitrage occurs primarily among firms in the top accrual decile. Asymmetry is only present on NASDAQ. Thus, there is short arbitrage of the accrual anomaly, but short sale constraints limit its effectiveness.

  


 

Professor Terry Shevlin

Real Effects of Accounting Rules: Evidence from Multinational Firms’ Investment Location and Profit Repatriation Decisions
Co-Authors:  John Graham and Michelle Hanlon
Accepted at: Journal of Accounting Research

October 2010
 

We analyze survey responses from nearly 600 tax executives to better understand corporate decisions about real investment location and profit repatriation. Our evidence indicates that avoiding financial accounting income tax expense is as important as avoiding cash income taxes when corporations decide where to locate operations and whether to repatriate foreign earnings. This result is important in light of the recent research about whether financial accounting affects investment and in light of the decades of research on foreign investment that examines the role of cash income taxes but heretofore has not investigated the importance of financial reporting effects. Our analysis suggests that financial reporting is an important factor to be considered in the policy debates focused on bringing investment to the U.S. 

  


 

Professor Terry Shevlin

Why Do CFOs Become Involved in Material Accounting Manipulations?
Co-Authors: Mei Feng, Weli Ge and Shuqing Luo
Accepted at: Journal of Accounting and Economics

September 2010
 

This paper examines why CFOs become involved in material accounting manipulations. We find that while CFOs bear substantial legal costs when involved in accounting manipulations, these CFOs have similar equity incentives to the CFOs of matched non-manipulation firms. In contrast, CEOs of manipulation firms have higher equity incentives and more power than CEOs of matched firms. Taken together, our findings are consistent with the explanation that CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs, rather than because they seek immediate personal financial benefit from their equity incentives. AAER content analysis reinforces this conclusion.

  


 

 

Professor Terry Shevlin

The value of a flow-through entity in an integrated corporate tax system
Co-Author: Alex Edwards
Accepted at: Journal of Financial Economics

August 2010
 

In an integrated corporate tax system, resident shareholders receive a tax credit for corporate tax paid that can be used to offset personal tax on dividend income. Nonresident and tax-exempt (pension plan) investors cannot use the tax credit on corporate dividends and thus prefer to invest in flow-through entities. We estimate the value of the flow-through entity to nonresident and pension plan investors by examining the price change around the date of an unexpected announcement of a change in tax law related to Canadian publicly traded income trusts units creating an entity-level tax that makes them no longer tax-favored to these investors.

  


 

Professor Joanna Ho
Title: “The Impact of Management Control System on Efficiency and Quality Performance – An Empirical Study of Taiwanese Correctional Institutions”
Co-authors: Cheng-Jen Huang and Anne Wu
Accepted at: Asia-Pacific Journal of Accounting and Economics

May 2010

Management control system (MCS) has been widely suggested as a key framework with which organizations can utilize to increase the probability that people make decisions and take actions congruent with the entire goals of the organizations.  Most of the previous studies have mainly focused on efficiency performance and we have little knowledge of the impact of management control systems on both quality and productivity performance.  In this study, we use both non-parametric data envelopment analysis (DEA) and parametric stochastic frontier analysis (SFA) to examine how MCS affects efficiency and quality performance in correctional institutions.  Our results show that correctional institutions in Taiwan have considerable technical inefficiency which is attributable to their unfavorable resource usage.  We also find that correctional institutions with tight MCS have higher efficiency and quality performance.  Our overall results support the argument that tight control systems can be used to achieve efficiency and quality performance.

  


 

Professor Joanna Ho
Title: “Corporate Governance and Returns on Information Technology Investment: Evidence from an Emerging Market”
Co-authors: A. Wu and Sean X. Xu
Accepted at: Strategic Management Journal

February 2010

Prior studies have reported mixed findings on the impact of corporate information technology (IT) investment on firm performance. This study investigates the effect of corporate governance, an important management-control mechanism, on the IT investment-firm performance relation in the Taiwanese electronics industry. Specifically, we explore board independence and foreign ownership, which have increasingly become salient factors concerning corporate governance in emerging markets. We address their roles across firms of different sizes and in industries where degrees of competitiveness run a wide gamut. Our results show a positive moderating effect of board independence on the IT investment-firm performance relation, especially when competition intensifies. Furthermore, we find that the greater the foreign ownership in small firms, the more positive the IT investment-firm performance relation, suggesting that foreign investors may bring IT expertise to help small firms reap the benefits of using IT.

  


 

Professor Lucile Faurel
Title: “Post Loss/Profit Announcement Drift”
Co-authors: Karthik Balakrishnan and Eli Bartov
Accepted at: Journal of Accounting and Economics

January 2010

We document a market failure to fully respond to loss/profit quarterly announcements. The annualized post portfolio formation return spread between two portfolios formed on extreme losses and extreme profits is approximately 21 percent.  This loss/profit anomaly is incremental to previously documented accounting-related anomalies, and is robust to alternative risk adjustments, distress risk, firm size, short sales constraints, transaction costs, and sample periods. In an effort to explain this finding, we show that this mispricing is related to differences between conditional and unconditional probabilities of losses/profits, as if stock prices do not fully reflect conditional probabilities in a timely fashion.

 


 

Professor Alexander Nekrasov

Title: “Fundamentals-Based Risk Measurement in Valuation”
Co-authors: Pervin Shroff
Accepted at: The Accounting Review

October 2009

We propose a methodology to incorporate risk measures based on economic fundamentals directly in the valuation model.  Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market-wide factors.  We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. We show how the covariance risk estimate can be transformed to obtain the fundamentals-based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama-French three-factor model.  We further find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor and largely explains the “mispricing” of value and growth stocks. Our study highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk.

 


 

Professor Siew Hong Teoh
Title: “Driven to Distraction: Extraneous Events and Underreaction to Earnings News”
Co-authors:
David Hirshleifer and Sonya Seongyeon Lim
Accepted at: The Journal of Finance

October 2009

Recent studies propose that limited investor attention causes market underreactions. This paper directly tests this explanation by measuring the information load faced by investors. The investor distraction hypothesis holds that extraneous news inhibits market reactions to relevant news.We find that the immediate price and volume reaction to a firm’s earnings surprise is much weaker, and post-announcement drift much stronger, when a greater number of same-day earnings announcements are made by other firms. We evaluate the economic importance of distraction effects through a trading strategy, which yields substantial alphas. Industry-unrelated news and large earnings surprises have a stronger distracting effect.
 


 

Professor Joanna Ho
Title: “How Changes in Compensation Plans Affect Employee Performance, Recruitment and Retention – An Empirical Study of A Car Dealership”           
Accepted at: Contemporary Accounting Research
Co-authors: Ling-Chu Lee and Anne Wu
February 2009

 

Prior studies have examined how changes to a more performance-sensitive incentive scheme influence employees’ compensation and performance. However, they are examples from practice (e.g., Sears) of companies, changing to less performance-sensitive incentive schemes. This study reports that a change from performance-sensitive (commission-based) scheme to less performance-sensitive (base salary plus commission) scheme hurts employee performance.  We use performance data for 4,392 employees of a Taiwanese car dealership over a 56-month period.  Our results show that higher-performing employees were affected by the compensation plan change more than lower-performing employees.  Consistent with the predictions of selection effects, our results indicate that the less performance-sensitive plan retained fewer higher-performing salespersons and led to the recruitment of lower-performing sales staff. We also find that the greater compensation loss for an employee, the more likely she was to leave the dealership. The decrease in individual productivity did not translate into lower overall company performance.  Further analysis suggests that the company may have taken several steps (e.g., hiring more employees, changing the sales mix) to mitigate the losses resulting from lower individual productivity.

  


 

Professor Siew Hong Teoh
Title: “The Psychological Attraction Approach to Accounting and Disclosure Policy”

Co-author: David Hirshleifer
Accepted at: Contemporary Accounting Research
Winter 2009

We offer here the psychological attraction approach to accounting and disclosure rules, regulation, and policy as a program for positive accounting research. We suggest that psychological forces have shaped and continue to shape rules and policies in two different ways. (1) Good Rules for Bad Users: rules and policies that provide information in a form that is useful for users who are subject to bias and cognitive processing constraints. (2) Bad Rules: superfluous or even pernicious rules and policies that result from psychological bias on the part of the ‘designers’ (managers, users, auditors, regulators, politicians, or voters). We offer some initial ideas about psychological sources of the use of historical costs, conservatism, aggregation, and a focus on downside outcomes in risk disclosures. We also suggest that psychological forces cause informal shifts in reporting and disclosure regulation and policy, which can exacerbate boom/bust patterns in financial markets.

 


 

Professor Alexander Nekrasov

Title: “Fundamentals-Based Risk Measurement in Valuation”
Co-author: Pervin Shroff
Accepted at: The Accounting Review

October 2009

We propose a methodology to incorporate risk measures based on economic fundamentals directly in the valuation model.  Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market-wide factors.  We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. We show how the covariance risk estimate can be transformed to obtain the fundamentals-based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama-French three-factor model.  We further find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor and largely explains the “mispricing” of value and growth stocks. Our study highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk.

  


 

Professor Siew Hong Teoh
Title: “Accruals, Cashflows, and Aggregate Stock Returns”
Co-authors:
David Hirshleifer and Kewei Hou
Accepted at: Journal of Financial Economics

2009

This paper examines whether the firm-level accruals and cash flow effects extend to the aggregate stock market. In sharp contrast to previous firm-level findings, aggregate accruals is a strong positive time series predictor of aggregate stock returns, and cash flows is a negative predictor. In addition, innovations in accruals are negatively contemporaneoiusly correlated with aggregate returns, and innovations in cash flows are positively correlated with returns. These findings suggest that innovations in accruals and cash flwos contain information about changes in discount rates, or that firms manage earnings in response to marketwide undervaluation.

  


 

Professor Siew Hong Teoh
Title: “Systemic Risk, Coordination Failures, and Preparedness Externalities”

Co-author: David Hirshleifer
Accepted at: Journal of Financial Economic Policy

2009

Sometimes resources are badly employed because of coordination failures. Actions by decisionmakers that affect the likelihood of such failures are sometimes said to cause ‘systemic risk.’ We consider here the externality in the choice of ex ante risk management policies by individuals and firms: they are concerned with private risk, not with their contribution to systemic risk. One consequence is that individuals and firms become overleveraged from a social viewpoint. The recent credit crisis exemplifies the importance of this problem. The US tax system taxes equity more heavily than debt, and therefore exacerbates the bias toward overleveraging. A possible solution is to reduce or eliminate taxation of corporate income and capital gains. Preparedness externalities can also cause firms to become too transparent, and thereby subject to financial runs. We consider the implications for debates over fair value accounting.

 


 

Professor Morton Pincus
Title: “Earnings Management Strategies and the Trade-Off between Tax Benefits and Detection Risk:  To Conform or Not to Conform?”      
Accepted at: The Accounting Review
Co-authors: Brad Badertscher, John Phillips, Sonja Olhoft Rego
December 2008
 
This study extends earlier research concerned with whether and how managers exploit the generally greater discretion available under U.S. financial accounting standards vis-à-vis income tax rules to manage earnings (i.e., cook the books).  In particular, the study investigates the prevalence of, and firm characteristics that impact the choice between, managing earnings upwards in ways that do or do not have current income tax consequences (respectively referred to as “book-tax non-conforming” or “book-tax conforming” earnings management). We analyze companies that restated their earnings for shareholder reporting purposes due to accounting irregularities and find that restating companies generally employed earnings management strategies that increased the earnings they reported to shareholders without increasing the companies’ taxable earnings. Moreover, we find that companies traded off the net present value of tax benefits against the net expected costs of being detected as an earnings manager.

  


 

Professor Siew Hong Teoh
Title: “Do Individual Investors Cause Post-Earnings Announcement Drift? Direct Evidence from Personal Trades”
Co-authors:
David Hirshleifer, James N. Myers & Linda A. Myers
Accepted at: The Accounting Review (American Accounting Association)

2008

This study tests whether naïve trading by individual investors, or some class of individual investors, causes post-earnings announcement drift PEAD[1]. Inconsistent with the individual trading hypothesis, individual investor trading fails to subsume any of the power of extreme earnings surprises to predict future abnormal returns. Moreover, individuals are significant net buyers after both negative and positive extreme earnings surprises, consistent with an attention effect, but not with their trades causing PEAD. Finally, we find no indication that trading by individuals explains the concentration of drift at subsequent earnings announcement dates.